Speculation: buying and selling currencies to make profit from changes in exchange rates due to expectation. Expectation currency appreciate~currency buying~ appreciation.

Use of foreign currency reserves

1 of 10

Freely Floating Exchange rates: Consequences

Inflation:

Cost push: Depreciation ~ import price of factors of production increase ~ SRAS increase. (the more inelastic, the greater the inflation) If a country is importing factors of production and carrying out specialisation, it will not diversify and therefore become more and more inelastic

- No easy of adjustment. Large or persistent current account deficits require large quantities of foreign reserves or foreign borrowing. Or, use contractionary policies, trade protection, exchange control à not beneficial.

- Monetary policy is used to manipulate the currency, not the economy. Contractionary.

- Borrowing from abroad to increase flows of funds may lead to high levels of debt

- Disadvantages of trade protection. (Misallocation etc.)

Floating

- Uncertainty, more currency speculation that is destabilising

- May rely on depreciation of the currency to become more competitive. Worst case, may devalue in order to be more competitive (China)

- If there is a current account deficit, there must be a financial account surplus which provides it with the foreign exchange it needs to pay for the excess of imports over exports. (investments in physical or financial capital by foreigners (including loans))

- If there is a current account surplus, the country is accumulating foreign exchange (as it earns more foreign exchange from exports than it pays out to buy imports), which can be used to buy assets abroad.

The ability of a country to go on indefinitely financing its current account deficit by selling off its assets depends very much on the confidence that foreign investors have in the domestic economy and currency. A belief of depreciation -> unwilling to invest

Lower cost of production for firms by shifting the SRAS and LRAS curve to the right

lower rates of inflation -> increase exports

increase productivity in order to increase export.

8 of 10

Marshall Lerner Condition and J-curve

Considering whether a depreciation reduces the size of the trade deficit. What matters is the changes in the value of exports and imports, not the quantity of imports and exports.

IMPROVE: PEDm + PEDx > 1

WORSEN: PEDm + PEDx < 1

Even if PEDm <1 and PEDx<1, if sum is >1 there will be an improvement

Depreciatin leads to a change in the price of exports only when expressed as FE.
(price of exports remains the same for domestic consumers)
Since domestic price stays the same, export revenue increases.
with PEDm >1 : fall in import expenditure
with PEDm <1 : rise in import expenditure -> consider the sum.

J-curve:

depreciation -> PEDm and PEDx <1 (due to time lags)

consumers and producers adjust to changes in prices PEDm and PEDx increase